High potential but a need for caution with reverse mortgages

New research from UNSW's Australian School of Business has warned of caution with reverse mortgages because of their risks and complexity. However it also shows they do offer the potential to provide retirement income for baby boomers who are retiring with insufficient superannuation savings.

In the paper 'Developing Equity Release Markets'Professor Michael Sherris and colleagues have been assessing the design and risks of reverse mortgages. He said "This is a really complicated product for most seniors - however borrowers may just want to access the cash, and don't realise they have in effect sold their home, although it's some time down the track."

"We also found that lump-sum RMs tend to be more proﬁtable and less risky for the lender than income stream RMs, and so they are happy for borrowers to take the lump sum option, which many do. Of course many borrowers have difficulties understanding the impact of compound interest and may depend on the advice of the person selling the Reverse Mortgage, but they really need to think about their future health and the need for aged care, whether they may want to move, and finally, and they may not have a good understanding of how long they may live."

Reverse mortgages work by the provider loaning the borrower a lump sum or an income stream and they then obtain a mortgage charge on the borrower's house. The contract is terminated upon death or permanent move-out of the borrower, at which time the house is sold and the proceeds are used to repay the outstanding loan balance. In effect the bank lends cash and gets it back by selling the borrowers house on their death.

He said "for someone approaching retirement without sufficient super savings, which will be the case for many Australians currently reaching retirement, it has potentially a lot of benefits in terms of providing retirement funding. I think an important matter is it's got to be looked at very carefully in the context of an individual's other assets and other pension income they may have, as well as their future health and longevity prospects."

Australia is one of many countries with a rapidly ageing population. Sherris said "many working members of superannuation funds are likely to live into their 90s, and perhaps beyond; we can now reasonably forecast for those entering the workforce a large portion of the population will live beyond 100 years. The average saver might currently need well over a million dollars in their super savings for a reasonable standard of living. With so many Australians owning their own home, reverse mortgages are a potential source of retirement savings."

In an earlier paper on "Risk Management and Payout Design of Reverse Mortgages" Michael Sherris (with Daniel Cho and Katja Hanewald) also said that there are also major risks for the provider with RMs. Interest rates may vary wildly, there is a risk of delayed termination of the borrower (they may live too long), and house prices could go down.

Professor Sherris also cautioned "these risks also face individuals who are considering using these products, which also includes shared equity or home reversion schemes, adding to the complexity of the financial decisions involved with RMs."

For further comment call Michael Sherris on 02 9385 2333 or m.sherris@unsw.edu.au